This article was written by Zuora CEO and Founder Tien Tzuo and originally published at Marketwatch.com.
Investors should watch how executives address ASC 606 in third-quarter earnings.
Uber’s reported revenue is being cut in half. IBM plans to spend an unexpected $35 million-40 million. And General Motors might have to reduce its balance of earnings by $1 billion next year. Why?
New accounting standards ASC 606 and IFRS 15 will force companies to completely re-evaluate when and how they account for their revenue. Right now, thousands of accountants are scouring through old contracts to determine whether their sales need to be booked differently.
After 12 years of work, the Financial Accounting Standards Board (FASB) and their international counterpart the International Accounting Standards Board (IASB) issued new standards for recognizing revenue from contracts with customers in 2014. The goal was to simplify and harmonize revenue recognition practices globally. The new standards are based on one overarching principle: “Companies must recognize revenue when goods and services are transferred to the customer, in an amount that is proportionate to what has been delivered at that point.”
But for those that don’t put in the work now, misappropriation of standards might cause revenue recognition errors. These errors are the No. 1 reason for restatements, which history shows us can lead to firings, stock-price drops, jail time and a tarnished reputation.
If you’ve been in Silicon Valley as long as I have, you might remember when the CEO and CFO of CA Technologies went to jail for falsely reporting $2 billion of revenue in 1999 when numerous license agreements were finalized after reporting periods had closed.
“With the FASB ASC 606 accounting rules, we get lunatic things like software companies recognizing term licenses upfront despite not getting the cash. This is what Enron did and, as I recall, that episode didn’t work out super well for anyone,” said Richard Davis, an analyst at Canaccord Genuity.
With ASC 606, might we see more of this in 2018? I think so.
But don’t take my word for it. Here’s what a finance executive, an accountant, a hedge-fund manager and a management consultant have to say about it:
If you had one prediction to make after the standard goes into effect, what would it be?
- Joe Bishop, head of equities at Pine River Capital:“The new standard is more aggressive on revenue recognition, even in cases where cash has not been collected from the customer. Surprisingly, this move reverses nearly two decades of more conservative accounting standards following the scandals of the late 1990s and early 2000s. I worry that, in the long term, this change will increase the chances that investors will be misled.”
- Tim Saunders, vice president of finance at Tintri:“The expression ‘lost revenue’ will become a very familiar one to CFOs, financial analysts and investors soon after the standard goes into effect, although the phrase is virtually unknown today. Companies will highlight the effect of deferred revenue that they can’t take to their income statement in explaining revenue fluctuations once the standard has taken effect.”
- Steve Hobbs, managing director at Protiviti:“Because many public companies have underestimated the impact of the new revenue recognition standard and are likely behind where they should be in preparing for the new standard, I anticipate we’ll see an increase in late 10-Q filings for the first quarter of 2018 and increased material weaknesses and restatements related to revenue. Regulators and external auditors will continue to have revenue recognition in their targets, particularly during the transition reporting periods.”
- Shauna Watson, global managing director for finance and accounting at RGP:“Despite all the pain and expense, CFOs will have more transparency into their revenue numbers and how they are contracting with customers.”
Are most investors blind to the potential effect of ASC 606? Why should they care?
- Pine River’s Joe Bishop:“Revenue recognition is always a paramount concern when examining business value, especially when digital goods and services are involved. ASC 606 can create significant discrepancies in how revenue is recognized in similar economic transactions depending on the terms of a contract. Caveat Emptor.”
- Tintri’s Tim Saunders:“In my opinion, most investors are completely unaware of the impact of ASC 606, as they have received virtually no guidance from most public companies on what revenue under the new standard will look like. In some cases, a company’s revenue recognition model may change significantly and investors will have to revise their valuation estimates.”
- RGP’s Shauna Watson:“It will be interesting to see how investors (and internal management reporting departments) deal with the lack of comparable information, and whether non-GAAP or unaudited comparable information is released. If revenue has completely disappeared because of the adoption of the standard, being wrapped into the cumulative effect adjustment, investors may want to account for that cash flow in their models despite not being characterized as revenue.”
Now that you know why everybody is suddenly talking about accounting, the question is what will you do about it? If you’re a C-Suite executive and your company doesn’t yet have a plan to put in the work to deal with these changes, it’s time to wake up. And if you’re an investor who doesn’t know how your companies are handling this change, make sure you pay extra attention to third-quarter earnings reports for guidance on how they will adopt the standards before the January deadline.
Tien Tzuo is CEO and founder of Zuora, a provider for software for CFOs.